At the root of the Hong Kong dollar’s recent weakness is a tightening of US dollar funding conditions that has worked in the greenback’s favour. Yet, higher US dollar funding costs don’t apply to Hong Kong alone. Globally, these may be uncomfortable times for non-US banks that have ramped up US dollar lending in recent years.

“The pressures that have built since the start of this year on the Hong Kong dollar are reminiscent of what happened 11 years ago,” wrote Simon Derrick, chief currency strategist at US bank BNY Mellon last week, when there was also a widening of the spread between the Hong Kong and the London interbank offered rates.

What has been seen recently in Hong Kong is “a further echo of market behaviour a year before the global financial crisis”, Derrick said. That is not to say that the BNY Mellon strategist is arguing that history will repeat itself but just that the resemblance to prior events is worthy of note.

With that in mind, at the very least it’s worth exploring whether any specific parts of the global financial system could be particularly vulnerable if a more elevated cost of accessing US dollar funding persists or if the pool of greenbacks available to borrow was to shrink.

Aggressive expansion of their US dollar loan books could leave Japan’s banks exposed if US dollar funding conditions continue to tighten

If tighter US dollar funding conditions are to persist or worsen, it might prove uncomfortable for Japan’s banks. Indeed, a piece in February from financial research group TS Lombard was pointedly titled “Is the Next Lehman Japanese?”

While “European banks played a decisive role in the subprime crisis,” TS Lombard wrote, Japan’s banks “may have taken over as the main systemic vulnerability”, having greatly expanded the size of their US dollar loan books in recent years, leaving themselves with huge US dollar funding needs, reminiscent of European banks in 2007.

That doesn’t mean there’s a Japanese Lehman just around the corner, far from it, but aggressive expansion of their US dollar loan books could leave Japan’s banks exposed if US dollar funding conditions continue to tighten.

A Bank for International Settlements working paper last month noted that “non-US global banks collectively hold US$12.6 trillion of dollar-denominated assets – rivalling those of US banks” and, strikingly, that while in the 2007-17 period, the global US dollar assets of European banks have shrunk by 42 per cent, those of Japanese banks have increased by 88 per cent to above US$2.5 trillion.

Additionally, the working paper notes, Japanese banks’ US dollar exposures have not only become the largest in size among non-US banks, but are also longer term and harder to scale back.

Last week, the International Monetary Fund wrote that US dollar-denominated loan book expansion by Japan’s banks has led to “a rise in interbank liabilities used to fund an increase in loans and securities” that has affected the Japanese banking system’s US dollar liquidity ratio as a whole.

While “overall, US dollar liquidity ratios have improved since the global financial crisis” the IMF stated that “the Japanese banking system’s liquidity ratio declined over the same period” even if “it currently stands at about 100 per cent”.

And while such a lending strategy can be perfectly viable as long as markets function smoothly and access to US dollar liquidity is cheap and plentiful, times change.

Commenting on the importance of swap markets, the IMF wrote that “the yen-dollar market – a crucial source of bank funding – may have become more pro-cyclical because of changes in market structure”.

The IMF noted that US banks’ dollar swap supply has not kept pace with the growing demand for swaps, with the result that non-traditional lenders, such as hedge funds and sovereign wealth funds, have stepped in to meet demand. These institutions now account for about 70 per cent of the supply of foreign currency derivatives to Japanese financial institutions.

It could be problematic for Japan’s banks if those non-traditional lenders prove unable or unwilling to continue filling that role.

In the meantime, even without such a development, US dollar funding conditions are already tightening. The jump in the London interbank offered rate since the beginning of 2018 has already had an impact on Hong Kong’s linked exchange rate system. Globally, it has materially increased costs for those who have to borrow dollars.

At the very least, the rising cost of borrowing the greenback to fund their greatly expanded US dollar loan books may well erode the profitability of the Japanese banks involved, even if market functionality remains unimpaired.

But, if events in Hong Kong are more than just an echo of 2007, the implications for Japan’s banking system could be much more serious.

Neal Kimberley is a commentator on macroeconomics and financial markets